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Executives

Richard E. Cleary – Chief Operating Officer and Assistant Secretary

Kevin E. Grant – Founder, Chief Executive Officer, President, and Chairman of the Board

Frances Spark – Chief Financial Officer and Treasurer

William Sheehan – Managing Director, Investments

Analysts

Steve C. DeLaney – JMP Securities LLC

Mark Devries – Barclays

Nick Agarwal - Wells Fargo Securities

Michael R. Widner - KBW

Douglas Harter – Credit Suisse

Eugene Fox – Cardinal Capital Management

Ken Bruce – Bank of America Merrill Lynch

Arren Cyganovich - Evercore Partners

Jim Young – West Family Investments

CYS Investments, Inc. (CYS) Q1 2013 Earnings Call April 18, 2013 9:00 AM ET

Operator

Good morning and welcome to the CYS Investments Inc. 2013 First Quarter Earnings Conference Call. During management’s presentation, your line will be in a listen-only mode. At the conclusion of management’s remarks, there will be a question-and-answer session. I will provide you with instructions to enter the Q&A queue after management’s comments.

Management has requested that we remind you that certain information presented and certain statements made during management’s presentation with respect to future financial or business performance, strategies or expectations may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements indicate or are based on management’s beliefs, assumptions, and expectations of CYS’ future performance, taking into account information currently in the Company’s possession. Beliefs, assumptions and expectations are subject to change, risk and uncertainty as a result of possible events or factors, not all of which are known to management or within its control. If management’s underlying beliefs, assumptions, and expectations prove incorrect or change, then the Company’s performance and its business, financial condition, liquidity, and results of operations may vary materially from those expressed, anticipated, or contemplated in any of their forward-looking statements.

In any event, actual results may differ. Management invites you to refer to the forward-looking statement disclaimer contained in the company’s Annual Report on Form 10-K filed with the SEC, which provides a description of some of the factors that could have a material impact on the Company’s performance and could cause actual results to differ from those that may be expressed in forward-looking statements.

The company has asked me to note that the content of this conference call contains time-sensitive information that is accurate only as of today, Thursday, April 18, 2013. The company does not intend to and undertakes no duty to update the information to reflect future events or circumstances.

For opening remarks and introductions, I will now turn the call over to Rick Cleary, CYS’ Chief Operating Officer. Please go ahead, Mr. Cleary.

Richard Cleary

Thanks John. Good morning and welcome to CYS 2013 First Quarter Earnings Conference Call. Today’s call is being recorded and access to the recording will be available on the company’s website at ww.cysinv.com beginning at 3 pm Eastern Time this afternoon.

To better understand our results, it’d be helpful to have the press release that we issued last night. As in past releases, the earnings release includes information regarding non-GAAP financial measures, including reconciliation of those measures to GAAP measures, which will be discussed on this call.

I’d now like to turn the call over to our CEO, Kevin Grant.

Kevin Grant

Thank you, Rick. Good morning and welcome to our first quarter 2013 earnings conference call. As usual joining Rick and me this morning is our CFO, Frances Spark and Bill Sheehan from our investment team. We very much look forward to your questions.

Q1 was a fascinating quarter. There is a lot I would like touch on in the macro environment but let me start by walking through the improved spread environment and how we are approaching it. Currently we see the net spread on a hedged basis to be about 120 basis points in the 15-year market but closer to 150 basis points in the 30-year market. And as you read our release, you will see that we have added some 30-year securities.

The pickup available in the 30-year market widened substantially in February and we benefitted in two important ways. First, by having few 30-year mortgages going into the period we experienced only a small impact on our NAVs. And second, this cheapening provided an opportunity to allocate capital to the 30-year market sector, thus taking advantage of the opportunity. We very much welcome the opportunity.

During the quarter, the 10-year treasury did a 35 basis point round trip swing, yet short rates hardly moved. This played very well into our strategy of holding predominantly 15-year mortgages and avoiding the volatility of this 30-year except when they are exceptionally cheap. Additionally, implied volatility in the options markets continued to fall making hedging cost in the cap market even cheaper. The markets are keenly tuned in to every hint from the Fed, especially anything related to the end of QE, also known as Operation Taper.

Over the past several weeks, numerous Fed officials have noted that the Fed is studying and considering how and when to scale back their asset purchases and even the Chairman has mentioned it in hearings and public statements. There is meaningful coverage in the FOMC meeting minutes as well. This tells us that the Fed understands there are costs to QE. It also tells us that the Fed maybe sensing sustainable employment growth might be underway notwithstanding the last print, despite the substantial fiscal drag from the sequester and other systemic drags on growth in the U.S.

As I watched the MBS markets early in Q1, mortgage spreads seem to hit a wall where buyers simply said ROEs were not sufficient to make a levered equity investment. Spreads, particularly in the 30 year market bounced off that level and remain today at better level than we have had in many, many months actually nearly a year. So for our business it appears the bond markets have tested the bounds of minimum ROE in Q1 and the markets, the 30-year market in particular, has re-priced for better ROE. This is good news for us.

I don’t usually talk about Japan in these calls, but the policy shifts in Japan are so significant, it is worth spending a minute. Japanese leadership is embarking on a highly expansionary program with massive monetary stimulus followed by fiscal stimulus which of course will take quite a bit longer to implement. The BOJ's aggressive quantitative easing has multiple implications for the U.S. and our business. First, the engineered devaluation of the yen designed to promote growth in Japanese exports will very likely push some financial investors out of Japanese assets into other safe haven assets, and that means U.S. financial assets, probably large cap U.S. stock.

Second, the Fed has a new calculus. Yen based capital flight is a new source of liquidity in the dollar and dollar assets. Initially, this is likely to be U.S. treasuries but will expand from there. In many ways, the Fed's $3.2 trillion balance sheet should have an addendum tacked on to it, to include the new liquidity coming from yen flight. This means interpreting market signals is becoming more difficult both for us and for the Fed. Third, the higher liquidity in the U.S. market is very difficult to measure and identify its source. This means there is a heightened likelihood the Fed will get the timing wrong. This is why our hedging strategies are so focused on buying cheap optionality.

And fourth, non-Japanese manufacturers from autos to industrials and electronics have a new competitive realty in the form of cheaper competitors from Japan. This could weigh on U.S. exporters revenue and profitability. Many of these factors are being discussed widely in the markets, so what does it all mean for CYS and how can we turn this to advantage. The 30 year MBS markets cheapened substantially during the quarter as I mentioned, and we reallocated capital to this market. We also took advantage once again of the very, very cheap forward markets and bought assets out into those forward months.

We believe we executed very well buying most of the 30 year mortgage securities near the lows during the quarter, when the 10 year treasury was around 2%. We also took advantage of the new lows in option implied volatility and we now have $4.1 billion of caps to hedge the extension risk in addition to nearly $9 billion of vanilla swaps. This means we were able to buy back a lot of optionality inherent in mortgage securities at very, very cheap levels in the options market. We expect this combination to give us better ROE for many, many quarters to come.

Presently, we see the best risk adjusted ROEs in the 30 year market as long as we can use options, in our case caps, to protect us from the extension risk. It has partially re-priced for operation taper to commence in the second half of the year and the 10 year part of the yield curve has re priced for steady albeit modest payroll growth.

Other markets, notably gold are catching up to the re-pricing of operation taper almost forcing the Fed to continue to talk about it. This is a good environment for CYS and as we reinvest our roll off, we expect the ROE to climb over the next few quarters. We are now more hedged than we’ve ever been with more cheap, long dated optionality built into those hedges than ever.

With that, we’re very happy to take your questions. It will take the operator a few moments to assemble the queue. Operator, would you take over the call?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We have a question from Steve DeLaney from JMP Securities. Please go ahead.

Steve C. DeLaney – JMP Securities LLC

So you had some significant realized gains in the quarter of $47 million. It looks like we’re set about $0.27 a share. And just thinking about the excess of those gains over and above the dropping 15, your adjusted core dropped covered your dividend at 32, but it looks like the gain gives you a little additional taxable income. Can you just comment on how you and the board are looking at that as far as support for the dividend? I think in 2012 you showed us that you thought a year in specials was the right way to go. But any thoughts you could give us and give us about how the realized gains made play into your dividend policy I’d appreciate it. Thank you.

Kevin Grant

Thanks for the questions, Steve. When we take gains as part of normal portfolio rebalancing, we collect those gains and maybe we have some offsetting losses through the year. So when we get towards the end of the year the board needs to make a decision about how to pay it, when to pay it and so forth. We do not philosophically think that you’re supposed to just clip gains for the sake of maintaining a dividend. So we’re really (inaudible) and just the economic merits of the core portfolio. So, we’ll just see where we are later in the year. It’s too early to make an estimate of what the special might be if there’s a special.

Steve C. DeLaney – JMP Securities LLC

Got it. And it sounds what you’re saying is you’d rather hold back any additional you might have as more of a contingency as opposed to using it. You can’t certainly assume that you’re going to have gains every quarter because you do it more strategically than tactfully it sounds like tactically. So I think what you’re seeing and what I’m hearing you say is we shouldn’t necessarily assume that the solid first quarter gains might give us an increase in the quarterly dividend in the near term.

Kevin Grant

Yeah, that’s right. Realizing a gain really doesn’t go into your just regular distributions. It shouldn’t.

Steve C. DeLaney – JMP Securities LLC

Understood. Thank you for that clarification.

Operator

Our next question comes from Mark Devries from Barclays. Please go ahead.

Mark Devries – Barclays

Kevin, would you consider accelerating some of the turnover in your portfolio so you can take advantage of the stronger spreads you can get in the forward selling market?

Kevin Grant

The short answer is yes, absolutely. We need to maintain balance and so forth, but the forward market, also known as the dollar roll market is very compelling right now.

Mark Devries – Barclays

And are there any limitations on how much you might look to accelerate that?

Kevin Grant

There are some limits, but we’ve got plenty of room. We would probably do as much as we wanted. The real value is in the 30-year market right now. Not so much in the 15-year market. So a lot of it depends on how much 30-year that we want to have.

Mark Devries – Barclays

Okay. And then on the 30-year market, I mean I think you indicated spreads that imply ROEs closer to mid-teens and kind of the low-teens where your current dividend payout is. Or even kind of low double digits. What you think if we sustain these types of spreads the outlook is for the dividend distribution going out for the remainder of the year?

Kevin Grant

Well, as you can tell our dividend approach is to basically pay core plus drop. And if core plus drop goes up, you would expect our dividend to go up. If spreads stay where they are right now and we can reinvest our roll off, I think in Q1 it was $950 million or something like that. In the better spread environment that should get our ROE going up and should get out dividend going up.

Mark Devries – Barclays

Okay. And would you say that the current distribution kind of reflects that 10% ROE, that’s kind of at that wall that you referenced where the market's at. You know the levered returns were no longer adequate and where you saw spreads kind of hit that wall?

Kevin Grant

It sure looks that way. If you are watching the way the market behaved, it sure looked that way. You know private capital requires a certain ROE and our philosophy has been to be a very efficient provider of access to these markets. So we can have a better ROE than anybody else because of that when spreads hit that wall. And it just seems like sometime in January we hit that wall and really bounced off it, the market just rejected it.

Operator

Our next question comes from Nick Agarwal from Wells Fargo. Please go ahead.

Nick Agarwal - Wells Fargo Securities

My question is around the CPR drop in April from, I guess in the quarter it was 17.5 at 12.1. How much do you believe that drop is attributable to the 35% portfolio being '13 production?

Kevin Grant

It's going to be some for sure. I have Bill in the room. Maybe he has got some color on sort of expectations. You want to comment, Bill?

William Sheehan

Yes, Nick, I think it's a combination both of punting [sFAS] [ph] payers as well as newer production. But we culled through the portfolio by a bond by bond basis every single month. And so we are very careful when we see something we don’t like to sell it. And so that’s probably a bigger driver than just the new production. It's to get rid of the bad ones.

Operator

Our next question comes from Mike Widner from KBW. Please go ahead.

Michael R. Widner - KBW

Just a couple of questions. First on the forward purchases and kind of the re-balance. You have had a couple of quarters now where your average settled securities for the quarter are running right around 16 billion, about 4 billion of forwards. I mean is that a run rate that we should continue to expect kind of going forward or would you expect it to change materially either way from there.

Kevin Grant

Well, the forward market is so special, Mike, that it's hard for me to tell you what sort of run rate to model. But the forward market is so specialized it sure looks like that’s going to last for a while. So I think it's going to go on as long it is compelling to use the forward market the way it's been, we are going to keep accessing it.

Michael R. Widner - KBW

Okay. Yeah, I think that kind of says what you need to say. Let me ask you a question on the CPRs, and I just want to make sure I understand the numbers that are in the press release. In the text you mentioned a CPR of 17.5%. In the table that’s right after it, you indicate an average of 13.4%. You have also mentioned an April CPR of 12.1%. My guess is you have got some apples to oranges numbers in there but just wanted if you can clarify the different numbers that are showing up there.

William Sheehan

Sure Mike, this is Bill. The answer is, the 17.6% was the portfolio through the quarter and the 13.4% were the bonds that we held at quarter end. And then after culling some more bonds we had April at 12.1%.

Michael R. Widner - KBW

Okay. And then, so in the text you also mentioned scheduled and unscheduled principal repayment and I just want to make sure that the number you have given there, the 17.5% is sort of the voluntary prepay rate or is that -- are you including both the scheduled and unscheduled?

William Sheehan

Yeah, voluntary.

Michael R. Widner - KBW

Okay. I just want to make sure I got that. I think that is all from me. Appreciate the comments and the color.

Operator

Our next question comes from Douglas Harter from Credit Suisse. Please go ahead.

Douglas Harter – Credit Suisse

Kevin or Bill, I was hoping you could just walk through, as those bonds settle, does the yield or spread pick up continue or is that just a function of the current specialness in the forward market?

Kevin Grant

When we get to settlement date, we make a decision on whether to actually take the bond in and settle it and just put it on the balance sheet or either swap it out or roll it into a future months settlement. So ongoing role. We make that decision around just going into settlement date. If we roll the bond then it’s going to stay in that trough income. If we take the bond in it’s going to come into the more conventional measures and keep in mind that it will be coming in at a cost that’s lower than the market just because it was bought at such a favorable price. So I wish I could give you guidance. My basic thought is that this attractive dollar roll market is going to stay attractive for quite a while. So I would guess we’ll be living with this for a while.

Douglas Harter – Credit Suisse

So to the extent that it stays favorable you’d be more likely to continue to roll and continue to take advantage of that?

Kevin Grant

Yeah, that’s right.

Operator

Our next question comes from Eugene Fox from Cardinal Capital. Please go ahead.

Eugene Fox – Cardinal Capital Management

Can you talk about your share repurchase program, what you’ve done thus far and what your thoughts are given the changes in the market?

Kevin Grant

Happy to do it, Gene. We bought a small number of shares. Frances is pulling the number, but a small number of shares when the stock had very, very cheap and right now we see investment environment as better than buying our own stock back. So we’ll just see how the next couple of weeks go. Frances, do you have the number?

Frances Spark

Yes. As you can see we purchased back just over 640,000 shares for about $7.6 million and as Kevin indicated, we looked at this daily and made the determination as to what was the better use of our funds on those particular days.

Operator

Our next question comes from Ken Bruce from Bank of America. Please go ahead.

Ken Bruce – Bank of America Merrill Lynch

My question is one that’s probably difficult to answer, but I’m interested in how you interpret these headlines that continue to come up regarding the change of the director of the FHFA and how do you think that that impacts your business if at all and any thoughts around that please?

Kevin Grant

That is a difficult one to answer. The director of FHFA will be, once the permanent one is appointed, if that ever happens, will be walking into a pretty well-oiled machine with a lot of projects underway. The single security initiative has got some real traction and it’s moving along. So whoever takes that job, it’s almost like the deck chairs are already set and for any meaningful shift it’d be a major surgery to the FHFA and I think it’d be pretty controversial because the controversy has kind of died down. And the current acting director personally I think is doing a terrific job. I’m a big fan. So I actually don’t think it’s going to matter a whole lot at this point. Enough time has passed and enough is already underway that I don’t think it’s going to matter a whole lot.

Ken Bruce – Bank of America Merrill Lynch

And do you think that there’s any merit to this discussion about to degree that a more liberal for lack of a better word permanent director might take towards the whole discussion around principal forbearance within the Fannie and Freddie book has any real meaning to the way you think about the business or is it just noise in the market that continues to erupt from time to time?

Kevin Grant

I really view it as noise. It’s great political fodder and pander to the masses, but the reality is that a loan get some trouble and go seriously delinquent gets pulled out of securitization. So anything that’s in trouble is not in our portfolio because those things would have been pulled out. So if the governor wants to muck around with the on balance sheet assets within Fannie and Freddie, they can make that decision, but it comes out of the taxpayers' pocket.

Ken Bruce – Bank of America Merrill Lynch

Right, I guess the issues becomes to the degree that it changes consumers behavior around strategic default. That ultimately is where it becomes a little bit more of an issue for the MBS in the market is if somehow borrowers decide to strategically default on the basis that they could get a better deal from Fannie and Freddie on principle.

Kevin Grant

Well, I hear you, but I think the probability is extremely low.

Operator

Our next question comes from [Joe Saven from Saven Capital] Please go ahead.

Unidentified Analyst

My question was actually just buyback and repurchase, so you just got that. But thank you, good quarter and thanks for the extended commentary.

Operator

(Operator Instructions) And we have a question from Arren Cyganovich from Evercore. Please go ahead.

Arren Cyganovich - Evercore Partners

Thanks, I just wanted to hear your thoughts on whenever the Fed does started the tapering of the MBS purchases, what are your thoughts on what the impact of spread would be on 15-year and hybrid ARMs as they are not really the primary security that the Fed has been buying.

Kevin Grant

Yeah, it's an excellent point and question. The Fed is targeting the mortgage rates to the consumer and so that means basically 30-year threes and we really don’t have any of those. But there will certainly be correlations and so forth. I think it ends up being probably pretty minimal. The public statements by various Fed officials and [Lacker] was on the news this morning, is that they would start this very slowly and very carefully. And it would be over a very long period time that the taper would occur. So I think we actually got a picture of what's going to happen in February. The 30-year market widened about 40 basis points relative to the 15-year market and the 15-year market widened about 10.

And you know we have been around the market for a long time and it's kind of one of these cases of buy the rumor, sell the fact, if you follow. So that’s probably, I don’t know, call it two-thirds of what might happen, has already happened. This is why we are actually pretty excited about the mortgage market here because we think it's already priced in.

Operator

We have a question from Jim Young from West Family Investments. Please go ahead.

Jim Young – West Family Investments

With the decline in book that you experienced from the year-end '12 in the first quarter down to 12.87. Given what's happening in the markets, are you back to the year-end '12 book value or can you give us a sense of magnitude or volume approximately where the current book is? Thank you.

Kevin Grant

Yeah, thanks Jim. Mortgage prices are definitely back up. 30-year market has come up more than the 15-year market as you might expect just because of where it is on the yield curve. So, yeah, mortgage prices are pretty strong. I haven’t got the exact delta in front of me for mortgages. Do you happen to have that, Bill?

William Sheehan

Well, on a yield basis they are back over half way. So....

Kevin Grant

So half the retracement.

William Sheehan

Yeah.

Kevin Grant

But our waiting in 30-year is up so it's good news for us.

Operator

We have a question from Eugene Fox. Please go ahead.

Eugene Fox – Cardinal Capital Management

Kevin, can you elaborate on your comments on your hedging strategy?

Kevin Grant

Happy to. We are now 70% covered. So we have got 70% of the liabilities covered by some form of hedge. We have a lot of more caps today than we have ever had and we really like the caps, particularly when you have buy caps with low implied volatility, especially for long-dated caps, 7 and 10 years. And we like those because in a steepening yield curve environment, a cap uniquely gives you kind of this hockey stick payoff pattern. So in the scenario where the economy is better and the Fed really does implement operation taper, those hedges should give us a levered exposure to a steepening yield [curve environment which is precisely what you want coming from your hedge in that kind of environment. So we’re ecstatic that we’re able to execute at such low implied volatility. It’s really pretty fortunate.

William Sheehan

And the cap has actually come down quite a bit Gene since quarter end in terms of cost.

Analyst

That implies that you would have gains on them?

Kevin Grant

Some of the caps are gains.

Operator

(Operator Instructions). At this moment we have no questions.

Richard Cleary

Thank everyone and on behalf of Kevin, Frances, Bill, and the entire CYS management team, I would like to thank you for taking the time to participate and speak with us this morning. We thank you for your continued support and interest. Have a good day.

Operator

Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.

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